When a ratings agency like Moody’s, one of the big three ratings firms alongside Standard & Poor’s and Fitch Ratings, cuts a credit rating it implies that a particular country or company is less likely to repay its debt.

So should investors be concerned about Chinese stocks?

The vast majority of debt in China, both government and corporate, is held by domestic institutions, individuals and corporations. And many of these corporations are state-owned enterprises (SOE’s) anyway who will do what they’re told by the central government. A minor downgrade by a foreign ratings agency isn’t going to unleash a wave of bond selling (which would increase borrowing costs as interest rates would need to be higher to compensate lenders for more perceived credit risk).

The majority of debt issued by Chinese organisations is in local currency. And domestic institutions and individuals hold the great bulk of that.

China’s external debt (at 13 percent of GDP) is very low by world standards. External debt refers to the total amount of public and private debt owed to non-resident individuals and entities. Foreigners own a tiny 3 percent of China’s debt.

By comparison, Japan’s external debt is 74 percent of GDP. It’s 126 percent in Australia, 97 percent in the U.S., 38 percent in Brazil, and 24 percent in India.

This means that the price of Chinese debt (i.e. bonds) is less subject to the whims of global investors. So even if those foreign holders of Chinese debt did decide to sell, it would have relatively little impact on bond prices compared to another country where foreigners own a large proportion of sovereign debt.

Also, the vast majority of Chinese debt is denominated in renminbi, not foreign currency. Borrowings in local currency have a vastly different risk profile compared to U.S. dollar borrowings. For example, borrowing in U.S. dollars for a Chinese business operation which produces goods and services priced in local renminbi exposes the borrower to potential currency risk. If the local currency depreciates, the borrower needs to find a lot more local currency to pay back each dollar of debt.

It was huge foreign currency debt in countries like Thailand, Indonesia, Malaysia and the Philippines in the 1997 Asian financial crisis that caused financial mayhem when these currencies devalued by anywhere from 40 percent to 70 percent.

Why does China have so little foreign debt?

We attribute that largely to its very high savings ratio. China saves almost 45 percent of its GDP, the largest savings rate of any large economy in the world. This means that it can fund a great deal of its needs from internal savings. It does not need to rely on foreign debt.

So it’s not true that China’s downgrade is bad for the country. To the contrary, there are some potential negatives from such a downgrade.

One is the possible impact on the currency. Given the low level of foreign holdings of renminbi debt, the natural way for the market to bet against China in light of this downgrade would be to sell the renminbi currency itself.

The renminbi has been weakening gently, pushing closer to the rate of 7 renminbi to the U.S. dollar. This had been going on well before Moody’s downgrade. But the People’s Bank of China (PBOC) has been more active in the foreign exchange markets in recent weeks to maintain stability in the renminbi against the dollar.

As we frequently remind our readers, the Chinese authorities like stability!

Second, some Chinese companies do raise foreign denominated debt for their businesses. This downgrade may make that borrowing a little more expensive.

Third, China has been gradually opening up its bond markets to foreign investors through Hong Kong. Attracting capital via this route may be a bit more difficult following this downgrade.

It is possible that the institutional investors or ratings agencies like you to think that …

China’s downgrade is bad for investments — to keep you from buying Chinese stocks

What it really does, however, is highlight the broader issue of economic reforms, and the fact that they are not happening as quickly or as strongly as some investors (or ratings agencies) would like.

But in the short to medium term, we remain bullish on Chinese equities. And we have reason to believe that today’s China is like the US in the 50s, read it here. That’s why we recommended a specific China equity play in our most recent edition of The Churchouse Letter on top of our other Chinese stock recos.

And if you think that a sovereign credit downgrade is necessarily a bad thing for a country’s equity market, just remember that in 2011, Standard & Poor’s downgraded U.S. sovereign debt from AAA to AA+…

Since then, the S&P 500 is up nearly 100 percent!

Good investing,

Peter

About Peter Churchouse

Peter Churchouse spent decades in Hong Kong as the head of Asia Research and Regional Strategist at Morgan Stanley, one of the world’s top investment banks, and as a real estate investor. He is the editor of The Churchouse Letter.

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